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FRBSF

WEEKLY LETTER

October 30, 1987

Foreign Capital Inflows
The financial flows accompanying the large
United States current account deficits of recent
years have transformed the U.s. from a net international creditor of $141 billion in 1981, the
historic peak, to a net debtor of $264 billion in
1986. Correspondingly, gross U.s. liabilities to
foreigners have risen from $689 to $1,331 billion. Since sizable deficits in the u.s. current
account are expected to persist, further capital
flows into the United States should continue.
Continuing capital inflows have raised several
concerns about their effects on U.s. financial
markets. One major concern is that foreign portfolios will soon be saturated with holdings of
u.s. assets, leading to higher U.s. interest rate
levels and a lower value for the dollar. In fact,
some contend that private foreign investors have
shifted away from holding u.s. liabilities, and
that only foreign central bank intervention in
support of the dollar has sustained the aggregate
level of capital inflows in recent quarters without significant increases in U.s. interest rates.
A secondary concern centers around the rise of
foreign holdings of U.S. assets in relation to the
overall size of u.s. financial markets and the
resulting implications for the term structure of
interest rates. In particular, ifforeign investors
prefer holding proportionately less long-term
debt and more short-term debt than domestic
U.s. residents, then long-term rates may rise relative to short-term rates. Consequently, economic activity most influenced by long-term
rates, such as fixed-capital investment, may be
dampened.

central banks. u.s. liabilities to private foreign
investors consist of direct investment assets, corporate securities, and bank liabilities, as well as
Treasury securities. These stocks change from
year to year as the result of international capital
flows and valuation adjustments, except in the
case of direct investment assets, which are carried at book value.
Chart 1 reports the evolution from 1982 through
the first half of 1987 of the stock of foreign-held
U.S. liabilities, broken down between official
and private capital. The figures for 1987 are
obtainedhy adding the annualized flows for the
first two quarters of 1987 to the year-end stocks
for 1986, as valuation changes are not yet available for any part of 1987.
Over the period from 1982 to 1986, the
accumulation of u.s. liabilities to foreign resic .
dents was primarily due to foreign private investment in the United States. U.S. liabilities to
foreign governments remained relatively constant, although they rose somewhat in 1986. In
the first half of 1987, however, the growth ofprivately held liabilities slowed down, while the
stock of officially held liabilities increased. The
latter development is attributable to foreign central banks' intervention efforts to support the
dollar.

Recent capital inflows

To provide further insight into recent trends,
Chart 2 separates U.s. liabilities to foreign
private residents by type of asset. It shows that
foreign-held private holdings of u.s. Treasury
securities did slow down between 1985 and
1986, and declined in the first half of 1987.
Bank-related capital inflows slowed significantly
in 1987, following a marked increase in the
fourth quarter of 1986. However, foreign private
purchases of corporate securities increased
sharply in 1986 and 1987. Direct investment
assets also continued to grow, although somewhat more slowly this year.

U.S. liabilities to foreign residents include the
liabilities of the United States to both foreign
governments and foreign private investors. U.S.
liabilities to foreign governments, also referred
to as foreign official assets, consist largely of
u.s. Treasury securities purchased by foreign

Thus, it may be premature to conclude that private foreign investors have become more reluctant to add u.s. dollar assets to their portfolios
without sharply higher yields. Private investors
appear to be acquiring more non-government

This Letter examines these concerns about U.S.
capital inflows by looking at recent developments and evaluating the potential for future
financing of u.s. deficits through continued purchases of u.s. liabilities by foreign investors.

FRBSF
assets, particularly corporate stocks and bonds,
perhaps to diversify their portfolios.
Future accumulation

While there is as yet no clear indication of a
dampening in foreign private demand for u.s.
assets at existing interest rate and exchange rate
levels, concern still exists that the willingness of
foreighihVesforstbtontihUe tOatcumulate·U.5.
assets will dedinein the near future. In particular, itis felt that, as the share of u.s. assets in
foreign portfolios increases, the willingness of
foreign investors to acquire more U.5. assets will
diminish without significantly higner U.S. interest rates and/or a decline in the value of the
dollar.
To address this concern it is necessary to understand the motivation for foreign financial investment in the United States. Much ofthe increase
in U.S. asset holdings by foreigners in recent
years can be attributed to a desire to increase
the relative share of such assets intheir portfolios because of attractive relative U.5. interest
yields. Over the period 1982 to 1986, U.5. real
shorHerm rates wereroughly two percent above
comparableyieldsinjapan. In addition, foreign
investors favor U.S. financial markets for their
efficiency, relative stability, and above all,
liquidity.
The ongoing liberalization of international capital flows, combined with the widespread
deregulation of financial markets all over the
world, and particularly in japan, have been
other factors behind U.5. capital inflows. Thus,
for example, the proportion of foreign securities
in the portfolios of financial institutions in japan
has risen from 6 percent in 1983 to around 15
percent in 1986.
While there obviously are limits to the extent to
which foreigners will increase the share of U.S.
assets intheir overall portfolios, sizable amounts
of capital inflows are still likely to be forthcoming as a resultof foreign saving and growing
foreign wealth. In fact, the acquisition of U.5.
assets has not beenall that large in relation to
world savings. It is estimated that in recent years
the United States has absorbed only about 9 percent of estimated gross savings abroad.
Moreover, despite sizable additions to foreign
holdings of U.S. assets during recent years, estimates by Morgan Guaranty indicate that these

holdings remain very small in relation to foreigner's total assets. For example, gross foreign
liabilities oftheUnited States to western Europe
at the end of 1982, amounting to $321 billion,
represented just above 1 percent of western
Europe's estimated total financial and nonfinancial assets, and less than 3 percent of financial
assets alone. By the end of 1985, the total
amounted to $518 billion, but the ratios had
reached only an estimated 1112 percent for total
assets and less than 4 percent for financial
assets. The ratios for japan are even smaller. At
the end of 1982, gross liabilities of the United
States to japan, $103 billion in total, represented
less than half a percent of japan's total assets
and less than 1 percent of its financial assets. At
the end of 1985, with total liabilities rising to
$156 billion, these ratios had risen to just above
half a percent and above 1 percent, respectively.
Thus, the data suggest that often-cited concerns
about the saturation of foreign portfolios and
resulting pressures on the level of U.S. interest
rates also are premature. The potential for further large-scale capital inflows into the United
States is far from exhausted.

Asset preferences
Even if the magnitude of total foreign capital
inflows continues at recent levels, it has been
argued that the increasing accumulation of foreign asset holdings in the United States might
significantly affect the term structure of interest
rates. According to finance theory, equilibrium
asset returns shOuld depend on a weighted average of the risk preferences and risk assessments
of different groups of investors in financial markets, with the weights depending on the relative
market investments of each group. Thus, if U.5.
domestic and foreign investors' risk preferences
were to differ, or, in the parlance of finance theory, domestic and foreign investors have different "preferred habitats," then asset returns in
the United States would change as foreigners
increase their presence in U.5. financial markets.
In particular, the returns on those assets preferred by foreign investors in comparison to resident U.5. investors will be less than otherwise.
Foreign investors in U.S. asset markets may
exhibit portfolio preferences different from those
of U.5. investors for a variety of reasons. First,
differences in available assets across countries
imply that individual assets provide different risk
diversification benefits to domestic and foreign

Chart 1
U.S. Liabilities to Foreign
Official and Private Residents

$ Billions
1,200
1,100
1,000
900
800
700
600
500
400
300
........................'C>fficial
200
100
a +---,-----r--.,----,----,--,---,*.-----,
1982 1983 1984 1985 1986 1987
* Through second quarter.

......

investors. Second, because investors in different
countries are likely to have different income
streams, the use of individual assets as hedging
instruments will vary for domestic and foreign
investors. Last, underlying aspects of asset preferences such as the degree of risk aversion may
vary across countries because of cultural and
societal differences. For any or all of these reasons, foreign investors in U.s. financial markets
may prefer to hold either more or less long-term
assets overall, or more bonds or more equity
securities, etc., than resident U.s. investors.
To explore the significance of possible differences in preferences, it is useful to compare
the composition of foreign private and official
holdings of U.s. financial assets to the corresponding composition of financial asset holdings
by resident u.s. investors. Flow of funds figures
for year-end 1986 indicate that foreigners hold
44 percent of their U.s. assets in the form of U.s.
federal, state, and local government securities well above the 29 percent held by U.S. domestic
residents. In contrast, foreigners hold only 17
percent of their u.s. portfolios in U.S. corporate
equities - below the 22 percent share of
domestic residents. Foreignand u.s. investors
also differ somewhat with respect to the maturity
composition of their debt holdings. The former

Chart 2
U.S. Liabilities to Private Foreign Residents
$ Billions

500
450
400
350
300
250
200
150
100

..

,.""".....

-'....
..
,

..

,

.....

............ II.·........ Treasury Securities
a +---,------r--.,--,..---,----,---:*;;--,

50

*

1982 1983 1984 1985 1986 1987
Through second quarter.

hold roughly 40 percent of their debt holdings in
short-term form, the latter, 30 percent.
If these portfolio preferences remain unchanged
over time, then, according to the argument discussed above, as foreigners increase their presence in U.s. financial markets, the required
return on long-term debt may rise above recent
average levels. However, since the portfolio
shares of foreigners do not differ all that substantially from those of domestic investors, this effect
may not be of much empirical significance.

Conclusions
The trend toward more foreign official holding
of u.s. government securities should not be a
source of concern since overall foreign private
demand for u.s. assets, particularly for corporate securities, appears strong. The normal
growth of foreign wealth should generate
enough demand for u.s. assets without significantly higher interest rates, although the composition of this demand may change. Changes in
the composition of capital inflows may influence
the relative returns for different types of U.S.
assets, butthey would do so without necessarily
affecting the general level of interest rates.

Reuven Glick

Opinions expressed in this newsletter do not necessarily reflect the views of the management of the Federal Reserve Bank of San
Francisco, or of the Board of Governors of the Federal Reserve System.
Editorial comments may be addressed to the editor (Gregory Tong) or to the author .... Free copies of Federal Reserve publications
can be obtained from the Public Information Department, Federal Reserve Bank of San Francisco, P.O. Box 7702, San Francisco
94120. Phone (415) 974-2246.

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BANKING DATA-TWELFTH FEDERAL RESERVE DISTRICT
(Dollar amounts in millions)

Selected Assets and Liabilities
large Commercial Banks
Loans, Leases and Investments 1 2
Loans and Leases 1 6
Commercial and Industrial
Real estate
Loans to Individuals
Leases
U.S. Treasury and Agency Securities 2
Other Secu rities 2
Total Deposits
Demand Deposits
Demand Deposits Adjusted 3
Other Transaction Balances4
Total Non-Transaction Balances6
Money Market Deposit
Accounts-Total
Time Deposits in Amounts of
$100,000 or more
Other Liabilities for Borrowed MoneyS

Two Week Averages
of Daily Figures

Amount
Outstanding
10/7/87
208,389
184,454
51,205
71,508
36,974
5,412
16,907
7,028
206,833
52,158
36,368
20,240
134,436
43,933
31,291
24,938
Period ended
10/5/87

Change from 10/8/86
Percent'
Dollar

Change
from
9/30/87

-

-

-

1,723
1,796
376
1,336
92
4
64
9
1,753
2,900
13,419
662
485

-

4,708
1,702
763
4,909
4,373
210
4,077
1,073
395
621
276
2,269
2,042

268

-

285
367

-

-

-

-

1
2

3
4

S
6
7

°

158
157

-

-

1.1

-

0.7
12.6
1.4

2,458

-

5.2

3,004
4,081

-

8.7
14.0

Period ended
9/21/87

Reserve Position, All Reporting Banks
Excess Reserves (+ ljDeficiency (-l
Borrowings
Net free reserveS ( +ljNet borrowed( - l

-

2.3
0.9
1.5
7.3
10.5
3.7
31.7
13.2
0.1

27
91
63

Includes loss reserves, unearned income, excludes interbank loans
Excludes trading account securities
Excludes U.5. government and depository institution deposits and cash items
ATS, NOW, Super NOW and savings accounts with telephone transfers
Includes borrowing via FRB, TT&L notes, Fed Funds, RPs and other sources
Includes items not shown separately
Annualized percent change

-